ANALYSIS: The changing factors of value

AXA Real Estate's Alan Patterson examines the four main factors that determine the quality of a property and how these have evolved in an increased risk environment.

In determining the quality of a property asset, the four main factors that investors usually consider are: lease length (or ‘stickiness’ of the occupier), building quality (normally, the more modern, the better), tenant quality (in the vernacular, covenant strength), and location. In the difficult occupier markets that we have had since 2006/7, the tenant quality combined with lease length provided certainty of income, which meant that any debt servicing costs could at least be met – and that also helped preserve capital values.

Of the four factors, however, the lease length and the building quality are inherently depreciating components, with the former normally having a much shorter life than the latter. Strangely, the concept of depreciation of income flow received much more attention in the period prior to the advent of cash-flow appraisals, the exact opposite of what one would expect, when such aspects could be made much more explicit.

Times have moved on and risks have changed. In Europe, we are looking to a period of relative low economic growth, coupled with low inflation and interest rates. That might not be the ideal scenario for property investment performance, but the risks have reduced.

Lease length premium
Nevertheless, investors are still paying a premium for lease length. Now, it is clearly better to have security of income than not to have it, but markets have become more normalised and that premium should be a more-normalised amount. Those investors – and there are large numbers of them – that are willing to pay an exceptional premium for lease length are presumably doing so on the basis that the occupier market will be better in the future. But they need to be particularly sure that the risks are exceptional – and that the future strengthening of the market will at least compensate for the loss in the lease length premium over the period.

The third factor – tenant quality – is the one that best lends itself to risk reduction through diversification. Changes in tenant quality can appear random (witness profit warnings by quoted companies), but can be managed by avoiding excessive exposure to a particular tenant or business sector. Most investors factor tenant quality into their pricing based on their perception of the tenant’s ability to pay the rent. Unlike lease length, however, there is no evidence that tenant quality deteriorates over time.

On the contrary, business failure is highest amongst young companies – those of less than five years old. Few, if any, property investors have a strategy of selecting properties on the basis of covenant-improvement expectations, but where an ‘improving tenant’ is located in a depreciating building, the risks of a mismatch will be growing.

Location mantra loses ring
The fourth factor used to be the most important, although ‘location, location, location’ seems to have lost some of its popularity as a mantra in the last couple of decades. In part, this may have been because car and road networks have opened up large tracts of land, thereby providing cheap alternatives for occupiers and making land less valuable.

There are, however, economic arguments to suggest that that trend has been reversing in more recent years. Typical ‘out of town’ businesses such as call centres and business parks are among those in decline, adversely affected by global competition or technological change. To attract skilled workers, higher value-add businesses – which are typically doing well – have moved back to city centres where higher rents are more than offset by the locational benefits.

The cycle changes the relative importance of the four factors, so it is not possible to conclude, in absolute terms, which is the most and the least important. We can, however, identify changes that are happening, or expected to happen, and reflect on whether they have been incorporated into investors’ perceptions. The cycle overlays what we believe is a secular shift in Europe, characterised by lower growth and an increased polarisation between ‘the best’ and ‘the rest’.

The risk for investors is that they treat this as merely part of the cycle and are pricing risks as if they were cyclical, rather than secular. Reconvergence is unlikely to occur to the same extent as in previous periods. As such, a reassessment of the four factors of pricing is required and investors will need to be far more discriminating than in the past in relation to location.

Alan Patterson is Head of Research & Strategy at AXA Real Estate